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Does the Income Effect Argue for Taxes?

July 27, 2004

Sometimes when you argue taxes with socialists they will answer the argument that taxes will reduce productive efforts since it reduces the rewards for productive efforts roughly as follows: "Yes, it is true that high marginal tax rates will reduce the rewards from productive efforts. But that is only the substitution effect. Countering the substitution effect is the income effect. Because taxes lowers people's income, they will raise the marginal utilty of more money and thus induce increased work efforts. We therefore cannot know a priori whether higher taxes will increase or lower work efforts, both scenarios can happen."

Some Austrian economists have tried to refute this argument by denying the very existence of an income effect. Yet this clearly does not hold up since the income effect can be derived using the Austrian value-scale approach. If people become poorer because the State taxes them then they will have to forego some of the things they want and only use their money to things they value more highly. This means that the marginal utility of additional money increases because of the increased poverty.

If a cheetah is "taxed" by a lion, that is, has her prey taken away from her by the lion, she will have to go hunting again immediately or else she will die. The cheetah in this case will work more as a result of the income effect. And of course, for humans too who want to achieve certain things more than anything else, the income effect will in some cases be more powerful than the substitution effect. A family who wanted to go on vacation but who loses their money because of taxation or other forms of theft will clearly be forced to work instead of going on a vacation.

But note first of all that even if we set aside the more fundamental point discussed below, then all the income effect would have achieved would be to force people to reduce their leisure and still not get any additional goods and services. Thus it would clearly reduce the utility of the people.

More importantly, though, is the other side of the income effect when it comes to the issue of taxes: namely the spending that taxes are used for. Because when we complain about taxes socialists try to argue that it is worth it because we are getting so much in return for our taxes. We get free or at least highly subsidized education, health care, roads, pensions, etc. The implication of this is that while taxes create a income effect which increases work efforts, the public spending financed by taxes will create a "negative" income effect (negative in the sense of decreasing work efforts) as we do not have to work to acquire education, health care, roads, pensions, etc.

While the higher taxes in Sweden versus the United States will create a bigger "positive" income effect in Sweden, the much higher degree of subsidies to higher education that it enables will also create a stronger "negative" income effect in Sweden as Swedes do not have to work to save money for their kid's college education as Americans do. (Swedish universities do not have tuitions and are fully payed by taxes. Moreover, one third of the money received in government student loans are actually welfare payments that students don't have to pay back.) Thus, assuming that public spending actually goes to something most people find useful, the "positive" income effect from taxes will be offset by the "negative" income effect created by public spending.

If we return to the example of the cheetah whose prey was stolen by a lion, we could clearly see how this created a "positive" income effect for the cheetah. But we should also realize that this creates a "negative" income effect for the lion, who now doesn't have to go hunting himself. If the lion hadn't been able to steal the cheetah's prey then the lion would have been forced to go hunting himself.

The only way in which the income effect will be "positive" is if there is government waste, that is, that the government is spending money on things which people in a free society wouldn't have purchased with their own money. Then there will be no "negative" income effect from the public spending. But getting people to work more even though it doesn't create more useful goods and services is clearly not a good thing since it will certainly reduce society's total utility because of the decrease in leisure.

Another way would be if higher taxes were used for reducing deficits and not for increased spending. Then disposable income for the private sector would clearly be reduced, creating an income effect. But this would only argue against the kind of "tax cuts" that so-called supply-side economists and President Bush favor, not against the more genuine kind of tax cuts that are backed by spending cuts.

There is thus no case against tax cuts and spending reductions from the income effect. The substitution effect case against big government remains however. Some people might argue that government spending could create an opposite kind of substitution effect that would counter the substitution effect from taxes. This is to some extent true when it comes to some government spending, on, for example, education and health care.

If government subsidizes education in public schools, then there will be a "negative" substitution effect in the form of an increased demand for these services. But the effect on production of these services will be limited since governments will have to put other limits on the size of these activities to prevent costs from spiralling out of control. In Sweden for example, despite having the highest level of taxation in the world, the police are largely absent in rural areas and the waiting period for medical operations of non-life threatening injuries and diseases is often several years.

And when it comes to other forms of government spending, like transfer payments, there will be no "negative" substitution effect increasing demand and thus production of some services. Indeed, when it comes to transfer payments such as welfare and unemployment benefits, which are only received if you do not work or if you work less, then this will actually enhance the substitution effect from taxes and further erode the incentive to make productive efforts. 

It therefore seems safe to say that the low growth rates in Western Europe (except for the low-tax havens of Ireland and Luxemburg) in the last decade are thus at least partially caused by its high taxes and extensive welfare state.

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Stefan M.I. Karlsson (email) is an economist currently working in Sweden. Comment on this article on the Mises Economics Blog. See also his archive.


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